Layman’s Guide to Taxes

Every citizen is obligated to pay income tax. First-timers, however, may find the process overwhelming and tedious, and some of the terms may go right over your head. It doesn’t have to be this way. 

Your taxes support roads, hospitals, schools, parks, and other public infrastructure and services. You can better grasp how your money is taxed and take control of your finances if you understand how taxes operate. Tax professionals can also assist you in aligning your tax strategies with your financial goals.

Here’s a collection of basic taxation information for beginners to help you understand what taxes are based on your income source.

What exactly are Taxes?

Governments collect taxes as a way of funding their operations. Taxes on imports, or tariffs, were the primary source of funding that the US government had before the income tax was introduced.

The citizen pays a wide variety of taxes, including income taxes, sales taxes, property taxes, capital gains taxes, excise taxes, and estate taxes. The level of taxes is a subject of disagreement among people. According to some, high taxes inhibit economic growth. Meanwhile, others argue that a robust tax system is necessary to distribute income and promote social welfare.

Some people find taxation difficult to swallow because most of us pay for things we don’t use and don’t care about. For example, your taxes may contribute to public schools that your kids don’t attend or policies you disagree with. For this reason, many people tend to hire tax managers to handle their taxes. Although the tax manager salary will be an additional expense on their end to avoid taxation complications, most people prefer paying their tax manager. 

Most people pay part of their tax bill via payroll taxes annually unless they do not work or work under the table. In addition to prepaying your income taxes and paying Medicare taxes and Social Security taxes, payroll taxes take money out of your paycheck and your employer’s bank account.

As a result, your pre-tax earnings are reduced by about 30% before they hit your bank account. Your post-tax earnings are generally lower than the salary you negotiated with your boss when you accepted the job. Because of this, it’s important to understand pre-tax and post-tax dollars. You can use any free online paycheck calculator to figure out how much money you’ll earn after taxes. Doing this is always smart, as it will give you an idea of how much you’ll be earning.

Next, let’s examine the types of taxes you will be paying to the government.

Taxes payable directly

Direct taxes are the taxes paid directly from an individual or business to the government body that imposes them. Individuals pay a direct tax to the federal and state governments, one paid by businesses on their profits and another paid by property owners.

In its original form, the federal income tax was supposed to be a direct tax rather than apportioned among states based on population. However, the law objected to a direct tax instead of being apportioned among states. In 1913, the 16th amendment overturned the US Supreme Court’s ruling, and the direct income tax was born.

The state and federal governments set direct taxes based on a percentage of the value of what is being taxed.

Taxes charged indirectly

A tax is generally added on goods and services such as imports, alcohol, gas, and tobacco transactions. The taxes include value-added taxes, sales taxes, excise or sin taxes, and tariffs.

The indirect nature of these taxes is because they do not flow directly from the payer to the government. For instance, you aren’t giving the government money when you pay a sales tax. That money is paid to the government by the merchant selling your goods.

In some sense, indirect taxes, by definition, are hidden. As an alternative to writing the government a check for the sales tax amount, you pay a higher price for the flat-screen TV to account for the sales tax. These taxes are also known as indirect business taxes.

Indirect taxes are applied uniformly to every transaction, regardless of the individual’s wealth. Some critics argue that this is unfair because indirect taxes have a greater impact on working and middle-class citizens.

Expenditures on taxes

A tax expenditure is a “revenue loss” resulting from a special tax code provision that can help lower a taxpayer’s tax bill. Tax deductions and tax credits are examples of tax expenditures. Alternatively, the government can eliminate tax revenue to provide financial assistance to different groups of taxpayers. Or promote activities that contribute to the economy or the community, such as homeownership or charitable donations.

A tax deduction reduces your taxable income. The net result is lower tax payments. Tax deductions are more valuable when your tax bracket (the percentage of your income you owe in taxes) is higher. Someone in the 35% tax bracket would get more out of a $1000 deduction than someone in the 15% tax bracket because 35% of $1000 ($350) is more than 15% of $500 ($75).

Rather than reducing your taxable income, tax credits reduce your tax liability. By taking a $500 tax credit, you owe the government 500 fewer dollars. Tax credits can be refundable or non-refundable. If your total tax liability (the amount you owe the government) is $800 and you receive a $1,000 non-refundable tax credit, your $800 tax liability will be canceled. Still, you will not be able to keep the remaining $200 ($1,000 – $800). However, the government would give you those $200 if you received a $1,000 refundable tax credit.

Final Verdict

In a nutshell, taxes aren’t something you can avoid. But understanding how taxes work can help you make smart decisions regarding your finances and increase your net income. It is possible to set up your finances properly to benefit from tax breaks and deductions through a good tax plan.

Consequently, you might owe fewer taxes. The key is to correctly manage your taxes to see exactly how much you owe the government and how much you’ve already paid in indirect taxes.

Doing this will give you a clearer idea of whether you can avail a tax deduction under 80C or not. Remember that doing your homework beforehand and knowing your taxable income can help you significantly save some bucks.